The Foreign Exchange Market International Finance Dr. A. DeMaskey

Learning Objectives What is the foreign exchange market, its function, participants, size, geographic and currency composition? What is the difference between spot, forward, and swap transactions in the foreign exchange market? What currency quotations are used by currency dealers and financial institutions when conducting foreign exchange transactions? What currency arbitrage opportunities do exist in the foreign exchange market, and how profitable are they?

The Foreign Exchange Market The FOREX market provides the physical and institutional structure through which the money of one country is exchanged for that of another country. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate.

Functions of the Foreign Exchange Market Transfer of purchasing power Provision of credit Minimizing foreign exchange risk

Structure of the Foreign Exchange Market An over-the-counter market No centralized marketplace A network of telephones, telex machines, computer terminals, and automated dealing systems. Not confined to any one country No fixed opening and closing times

The World of Foreign Exchange Dealing

Size of the Market Worldwide daily trading volume Daily trading volume in the U.K. U.S. daily turnover Daily turnover in Tokyo

Market Participants Two Tier Market FX Broker International Banks Bank Customers Central Banks Non-Bank Dealers

Transactions in the Interbank Market Spot Transactions Outright Forward Transactions Swap Transactions

Global Foreign Exchange Market Turnover Two of the three categories fell between 1998 and 2001 with spot market daily turnover falling the most, from $568 billion in 1998 to $387 billion in 2001. Forward transactions increased slightly from $128 billion in 1998 to $131 billion in 2001. Swaps fell to $656 billion in 2001 from $734 billion in 1998. The BIS attributes the introduction of the Euro, the growing share of electronic broking in the spot market and consolidation in banking as explanations for the reduction

Foreign Exchange Rate Quotations American Terms U.S. dollar price of one unit of foreign currency A direct quote in the U.S. An indirect quote in Europe European Terms Foreign currency price of one U.S. dollar A direct quote in Europe An indirect quote in the U.S.

Bid and Ask Quotations Bid Rate and Offer/Ask Rate Outright quotations Abbreviation Reversing Bid and Offer Rate Bid-Ask Spread

Cross Rates Exchange rate determined through the relationship to a widely traded third currency. Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars Assume the following quotes: Japanese yen ¥121.13/$ Mexican peso Ps9.190/$

Currency Arbitrage Capitalizing on the discrepancy in quoted prices. No investment No risk Locational Arbitrage Triangular Arbitrage

Locational Arbitrage When quoted exchange rates vary among locations, participants in the foreign exchange market can capitalize on the discrepancy. Suppose the euro is quoted in London at 0.6064-80 and the pound sterling is quoted in Frankfurt at 1.6244-59.

Triangular Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage. Example: Assume the following exchange rates are quoted in New York, Frankfurt, and London, respectively: $1.4443/£ $0.9045/€ €1.6200/£

Forward Transactions This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months

Forward Market Participants T r a d e r A r b i t r a g e r S p e c u l a t o r H e d g e r

Forward Quotations Outright Rate Swap Rate Discount or Premium Annualized Percentage Discount or Premium Swap Rate Expressed in Points

Swap Rate Outright forward rate = Spot rate ±Swap rate/point A point is the last digit of a quotation. Add points to spot rate if currency is trading at a forward premium. Subtract points from spot rate if currency is trading at a forward discount.

Bid and Ask Forward Quotations If forward ask in points > forward bid in points forward premium If forward ask in points < forward bid in points forward discount

Bid-and-Ask Forward Quotations in Points Suppose you receive the following quotes for pound sterling relative to the U.S. dollar for spot, 1-, 3-, and 6-month forward: “1.6075-85 10-15 14-22 20-30”